Most retail investors after the recent dud listings have reined in their return expectations from new public offerings. That is quite a comedown from the time when an initial public offering (IPO) allotment meant a neat killing on listing day. The momentum in the secondary market too has stalled, after the blinding comeback from the March 2009 low. Negative global cues are not helping the cause of those who believe that the recovery is here to stay. Does this state of affairs then leave the government’s planned disinvestment programme between a rock and a hard place? And then, was it something that the market should have really got excited about in the first place? Let’s face it, we have always been driven by a crisis to bring in “reforms” or move in a direction which spelled more accountability for the government. But for the government this time around, because of the fiscal situation, disinvestment is not an option but a compulsion. In an economy which is trying hard to find its feet, you can’t raise taxes without adverse implications for growth. That makes divestments imperative.

The fact also remains that, due to sloshing liquidity, there is sizeable institutional interest in public sector companies. This is amply demonstrated by the launch of dedicated funds from Religare AMC and Sundaram BNP Paribas AMC to invest in public sector stocks. While the government has almost run out of options to raise resources, why is there so much attention on the part of institutions?

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Fairly valued

Markets have seen a significant re-rating across sectors since December 2008

Source: BSE, Kotak Institutional Equities

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The new-found interest in public sector stocks is perhaps not because of the disinvestments story alone. When the markets are cruising, everyone wants to chase growth plays but when things take a turn for the worse they rush back to the old and staid. That explains why public sector companies were the best performers last year during the contagion.

Here is another convincing reason. Valuations are no longer compelling in frontline stocks. The BSE Sensex trades at 16.5 times the estimated consensus FY11 EPS of Rs 1050. Even so, the multiple hides the fact that many of the components are trading well over 20 times estimates for next year. All those who missed the rally as well as the ones with new inflows are fed up of waiting for the correction. They are desperately in the hunt for a sector that offers a limited downside but a sizeable upside. Though public sector stocks might not exactly fit the definition, in this kind of over-extended market they come close. Also major public sector companies like Bhel, NTPC or SBI are in sectors that will see continued action irrespective of how the global economy fares. Even better, there could even be perverse beneficiaries from slow global growth. The state-controlled oil marketing majors like BPCL, HPCL and IOC could actually gain if global growth slumps and takes the crude price down with it. These companies also have a consistent dividend paying track record that should help if your view precludes runway capital appreciation.

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Off mark

Successive governments have failed to meet disinvestment targets, barrin g the NDA

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Disinvestment, sure thing?

Sure, not everyone thinks disinvestment is a silver bullet for tattered government finances. So far the disinvestments proceed went to the National Investment Fund, but this year, looking at the bleak fiscal situation the government has decided to divert that money towards directly meeting the needs of social sector schemes like education and healthcare till March 2012.

Many PSUs are good investment themes as they enjoy significant business advantage and have strong balance sheetsVetri Subramaniam, Chief investment officer, Religare Mutual Fund

Says D K Joshi, principal economist, Crisil, “Disinvestment programme should not be viewed from the angle of plugging the fiscal deficit as it is a temporary provision, the long term solution is that you should set your public finances right.” Yet, in the past, disinvestments have proved fruitful as a stop-gap.

The NDA regime (1998-2004), mobilised Rs 33,700 crore over its tenure and pared the fiscal deficit from 6.5 per cent of GDP in 1998–99 to 4.5 per cent in 2003–04. The re-elected UPA government is trying to replicate that success and has kicked off the programme with the initial public offers of NHPC (National Hydro Power Corporation) and Oil India. Sunil Mitra, secretary, department of disinvestment is optimistic about getting a positive response from the markets for future issuances. “In case of NHPC and Oil India, more than 40 per cent participation was from domestic institutional investors, as it is we had a budget target of Rs 1120 crore in FY10 but we have already raised Rs 4260 crore,” he says.

Next in line are follow-on public offers from NTPC, REC and an IPO of Satluj Jal Vidyut Nigam. The government is also looking at divesting stakes in those listed PSUs, which have less than 10 per cent public shareholding. In case of unlisted firms, the government will list companies with a three year track record of net profit, positive networth and no accumulated losses. Based on just 10 per cent public shareholding criteria, the government could raise Rs 47,500 crore from 12 such companies (See table: Lot of headroom).

While the valuation gap between PSU and private sector peers may not be bridged it will certainly get narrowedJ Venkatesan, Fund Manager, Sundaram BNP Paribas

While in November the government has announced its disinvestment plan of listing all profitable large PSUs, and raise close to Rs 80,000 crore, how much of that intent gets stuck in bureaucratic inaction remains to be seen. In the past 16 years including FY10, the government has exceeded its disinvestment targets only five times (see graphic Off Mark on page 38 ). That makes one skeptical about achieving the target.

What’s the excitement about?

Surely, for the government the disinvestment option is an alluring one available to plug the deficit. But for you the retail investor, does it mean an opportunity to make money?

The first determinant of returns is how the markets pan out. There are investors who believe that the market is prone to a correction. If that is the case, the sentiment in the primary markets will be hurt and government plans for disinvestments may go through a tough terrain too. Vetri Subramaniam, chief investment officer, Religare Mutual Fund is in the camp that believes a correction may be in the offing in the absence of any significant positive triggers. Yet he has launched a public sector fund. Why? “It’s not just the disinvestment angle, many public sector units (PSU) are good investment themes as they enjoy significant business advantage and have strong balance sheets,” he explains. It then seems that market participants are positive about PSU stocks not only due to cheap relative valuations but also the future prospects for these companies. J Venkatesan, fund manager, Sundaram BNP Paribas echoes the same views. “Some select PSUs are both a valuation and growth story.” On an average, PSU Banks trade at 1.5 times book versus 2.5-3 times private banks, while the valuation gap between PSU and private sector peers may not be bridged it will certainly get narrowed, he adds.

The government stance is that public offers are a preferred route to encourage retail participation. Says Mitra, “We want to encourage wider retail participation and find resources other than tax revenues for asset creation, so IPO and follow-on public offering (FPO) will get precedence over other avenues.” Plus, disinvestments will help in sizing up the market too. Despite the PSU basket forming 30 per cent of India’s total market capitalisation, most of them have small free float and low public shareholding. Indices like BSE 100 and BSE 200 all are free float based, thus PSU weightage in these indices are very low and don’t reflect the right picture. Venkatesan says, “There are some 110 profit making PSUs which will have $160 billion market cap if all are listed, their share can go up to 40-45 per cent of the Indian market cap.”

While investor appetite will not be a problem, the trick will be to sell without hurting valuations and the ability of companies to raise capital in the future. For instance, the government has a 67 per cent stake in capital goods manufacturer Bhel. The additional 10 per cent stake being talked about will not only impact current valuations, but also reduce Bhel’s leeway in raising capital for future expansion plans without affecting its overall capital structure.

If the disinvestment plan is going to be just an exercise in paring stakes in listed companies, why bother as you can buy them in the secondary market? Lets look at NMDC and MMTC, both of which have a government stake of over than 90 per cent and most possibly will be out of the gate first, given the yawning gap between their free-float market cap and their total market cap. If we revisit our much harped point on valuations, we find that the free float market capitalisation values of MMTC and NMDC, for instance, are close to Rs 8,500 crore and Rs 8,050 crore, respectively, as compared with their total market capitalisation of Rs 1,70,000 crore and Rs 1,61,000 crore, respectively. While the low liquidity ensures that these stocks trade at a freak premium to their peers, the fundamentals don’t seem to justify the premium. Consider MMTC. The company operates on wafer-thin margins of 1.74 per cent with debt that is three times its net worth. There really is no justification for this stock to enjoy a P/E multiple of 1100. If at all MMTC gets subscribed at current valuations, then it would be a reflection of desperate institutions looking for an entry point.

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Barring a freak case like MMTC, there is one solid reason why investors can give public sector issues a chance. And that is reasonable valuations. You can accuse the government of not being opportunistic enough to time IPOs correctly, but that is also the reason they have handed out decent returns in the past. Public sector shares have thus not fared badly during the turmoil compared to aggressively priced private sector offerings. But then, unfortunately, IPOs coming at reasonable prices in sober markets like this mean very little by way of listing gains as seen recently. Vaibhav Sanghvi, director, Ambit Capital, cautions the retail investor saying “In case of PSU IPOs, investors should look at consistent returns rather than listing gains” “I don’t think it is going to be a pop up game,” he adds. Though past performance is no guidance for future prospects, the government IPO’s track record is comforting. Out of 21 offers by the government since the year 2000, 12 have outperformed the average Sensex return in the respective year. That still does not mean stocks will perform over the short term, because short-term returns are largely a function of overall flows into the market. For now, Subramaniam at Religare is hoping that the large savings pool with domestic investors will mean good appetite for IPOs. That the retail portion of some of the recently launched IPOs, have been undersubscribed does not seem to be dampening their enthusiasm just yet. Says Manish Sonthalia, fund manager, at Motilal Oswal, “If retail investors are not forthcoming, institutional investors will lap it up.” There again, it is a question on how attractive the pricing is. Subramaniam says, “In case of unlisted companies it would be based on fair pricing after peer comparison, however for FPOs while appetite will be there, investors will expect some margin of safety.” Margin of safety, you may get, but for big gains you will have to wait for a long time.

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Lot of headroom

A look at what the exchequer would rake in if it were to sell its stake in public sector companies

Source: BSE. * As on December 2, 2009

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Where are the big gains

The jackpot gains from disinvestments can come only by way of strategic sales which the government is not even talking about. For example, oil companies are currently trading at well below their replacement cost of Rs 600 to Rs 700 per share (IOC/HPCL/BPCL). For the market price to get closer to that level the government will have to first relieve the sector from the covert administered price regime. The same would apply to fertilisers. And then it is not just that one time opportunity but the scope for sustained gains on the business front. If we look at Hindustan Zinc, performance post sale has been stupendous. Hindustan Zinc turned profitable after it was sold to the Sterlite group: profits doubled to Rs 138 crore in FY03 (after the stake sale) and the company is currently raking in profits to the tune of Rs 4,396 crore.

Profits at Maruti also rose by an impressive 15 times to Rs 1,656 crore in FY08 from Rs 105 crore in FY02. Of course, both these companies benefited from the economic boom that followed their privatisation, but there were operational efficiencies as well. If a strategic stake sale is unlikely – and that would be the case if the government says it does not want its stake to fall below 51 per cent – it’s possible that the real value of the government’s shares will not be realised and once the euphoria dies down, these stocks will be back to trading at valuations lower than their private rivals. A long-term call therefore on public-sector companies may not be a great idea given their limited ability to fight competition from private players and the pressures from the political establishment.

The real worth of public sector companies can only be realised when the private sector steps in; reworks processes to get the best out of these badly-run, non-accountable establishments. This is a very tough task when the very act of sharing what actually belongs to the tax-paying public gets portrayed as an act of selling the “family silver” For now, let us look at the companies who have been lined up for the divestment parade.

We have segregated the stocks to watch on four parameters. Firstly there are stocks which fall in the 10 per cent minimum shareholding criteria. These are the companies in the listed space, which the government is serious about and will look at for divesting small stakes.

Secondly, there are large and profitable companies in the unlisted space, which the government would want to list, thus adding to higher variety of PSU stocks. Thirdly, there are companies, which have been talked about by the government in the media or public. And lastly, we pick out best PSU stocks liked by the market experts.